For some, the fiscal problems in the US and Europe are a case of bad politics getting in the way of good economics. This column argues that there was plenty of bad economics as well. It looks at the work of the two recent Nobel Laureates in offering some clear thinking.

The US and the EU, the most powerful economic areas in the world, are bedevilled by seemingly intractable fiscal problems. Their problems stem from a variety of sources; inconsistent promises of low taxes and high benefits, creative accounting, and financial bailouts have all contributed to mounting government debts, with no end in sight. Although politicians on both sides of the Atlantic prefer delay to action, the logic of the situation is inescapable – over some horizon, government spending and government revenue must match.

This year’s Nobel Prize in economics went to two economists who years ago laid out the bracing logic of government finance. Thomas Sargent is famous among economists for many things, but among them is “Some Unpleasant Monetarist Arithmetic,” a paper he wrote with Neil Wallace in 1981. His distinguished Nobel partner Christopher Sims is known partly for a 1994 paper “A Fiscal Theory of The Price Level” that connected the price level to fiscal policy. Both papers focus on the government budget constraint – the unavoidable connection between deficits, debt, and inflation.

These classic academic papers are strikingly prescient. They address, in different ways, the underlying logic of the problems we face right now. Governments finance their deficits by collecting taxes and borrowing. Their borrowing works because there’s an implicit promise to pay back principal and interest. If the magnitude of the debt calls this promise into question, something must give. Basic accounting tells us we will see some combination of lower spending, higher revenue, or – somehow – lower debt. In some cases, thankfully rare, governments reduce their debt through default, as Argentina did in 2002 and as Greece is contemplating today. In other cases, inflation reduces the real value of the debt. In still others, the government runs primary surpluses and the economy grows, making the debt more manageable. The budget constraint doesn’t tell us which of these things will happen, only that one of them must. Pension and healthcare obligations may not be honoured, taxes may be raised or inflation may increase, taxing consumers and debt holders indirectly. None of them are politically popular, but if governments don’t take action, history tells us that action will be imposed on them.

Thomas Sargent is also a significant economic historian and he has tested this theory by studying the connection between fiscal policy and inflation in several high inflation periods in Europe and the US. In nearly every case monetary reform required successful fiscal stabilisations to bring inflation under control. Sargent’s study of hyperinflation in interwar Europe also offers compelling reading on the consequences of government indecision.

A common currency, of course, takes one of these strategies off the table. If governments like Greece can’t reduce their debt through inflation, then a default where bondholders take a sizeable haircut on their debt becomes a more likely option, with all of the attendant costs in terms of lost output and higher unemployment. Sims predicted precisely this tension between centralised monetary policy and decentralised fiscal policy in a 1999 paper about the Eurozone.

In the case of the US, default is unthinkable so the uncertainty surrounds what else will have to give and what the costs will be. Some economists (eg Paul Krugman and Kenneth Rogoff) have openly advocated a policy of higher inflation to lower the real burden of the debt. Astonishingly, they do this without explicitly analysing or even discussing what the costs will be to US consumers and to the foreigners who hold 50% of the US debt. Inflation taxes those on fixed incomes like retirees, the poor who rely on cash, and foreign holders of US debt who are providing the country with liquidity.

In the absence of well-articulated credible plans for addressing fiscal imbalances, households and firms face greatly increased uncertainty about what commitments the government will fail to keep and what the costs will be. It is not surprising that the most prominent index of policy uncertainty is at an all-time high.

Thomas Sargent and Christopher Sims gave us a coherent framework with which to think about and discuss these critical policy issues. And they fully anticipated the difficult dilemmas we now face as a consequence of recent fiscal policy. Sargent and Sims did much of their prize-winning work at the University of Minnesota, one of the homes of ‘freshwater’ economics – the economics associated with the Universities of Minnesota, Carnegie-Mellon, Chicago, and Rochester that in the 1970’s challenged the prevailing Keynesian consensus. It is fashionable in some parts to dismiss this line of work as divorced from reality, having nothing useful to say about economic policy. But given their prescient and clear thinking about the nature of fiscal problems perhaps it would be better to call it ‘clearwater’ economics.